Tuesday, March 6, 2012

... I assume that most of those hearing or reading this speech at all closely are aware of the great divide that emerged in macroeconomics in the 1970s. For those who aren’t familiar with the story: in the 1930s Keynesian economics emerged as a response to depression, and by the 1950s it had come to dominate the field. There was, however, an undercurrent of dissatisfaction with that style of modeling, not so much because it fell short empirically as because it seemed intellectually incomplete. In “normal” economics we assume that prices rise or fall to match supply with demand. In Keynesian macroeconomics, however, one simply assumes that wages and perhaps prices too don’t fall in the face of high unemployment, or at least fall only slowly.

Why make this assumption? Well, because it’s what we see in reality – as confirmed once again by the experience of peripheral European countries, Portugal included, where wage declines have so far been modest even in the face of very high unemployment. But that’s an unsatisfying answer, and it was only natural that economists would try to find some deeper explanation.

The trouble is that finding that deeper explanation is hard. Keynes offered some plausible speculations that were as much sociological and psychological as purely economic – which is not to say that there’s anything wrong with invoking such factors. Modern “New Keynesians” have come up with stories in terms of the cost of changing prices, the desire of many firms to attract quality workers by paying a premium, and more. But one has to admit that it’s all pretty ad hoc; it’s more a matter of offering excuses, or if you prefer, possible rationales, for an empirical observation that we probably wouldn’t have predicted if we didn’t know it was there.

This, understandably, wasn’t satisfying to many economists. So there developed an alternative school of thought, which basically argued that the apparent “stickiness” of wages and prices in the face of unemployment was an optical illusion. Initially the story ran in terms of imperfect information; later it became a story about “real” shocks, in which unemployment was actually voluntary; that was the real business cycle approach.

And so we got the division of macroeconomics. On one side there was “saltwater” economics – people, who in America tended to be in coastal universities, who continued to view Keynes as broadly right, even though they couldn’t offer a rigorous justification for some of their assumptions. On the other side was “freshwater” – people who tended to be in inland US universities, and who went for logically complete models even if they seemed very much at odds with lived experience.

Obviously I don’t believe any of the freshwater stories, and indeed find them wildly implausible. But economists will have different ideas, and it’s OK if some of them are ones I or others dislike.

What’s not OK is what actually happened, which is that freshwater economics became a kind of cult, ignoring and ridiculing any ideas that didn’t fit its paradigm. This started very early; by 1980 Robert Lucas, one of the founders of the school, wrote approvingly of how people would giggle and whisper when facing a Keynesian. What’s remarkable about that is that this was all based on the presumption that freshwater logic would provide a plausible, workable alternative to Keynes – a presumption that was not borne out by anything that had happened in the 1970s. And in fact it never happened: over time, freshwater economics kept failing the test of empirical validity, and responded by downgrading the importance of evidence.

Monday, March 5, 2012

I generally try not to write about things I know almost nothing about, but here goes. Take everything that follows here as a kind of "thinking out loud" -- a struggle to put into words my thoughts about some apparently odd ideas in macroeconomics. I say "apparently" because I don't know enough to be sure. Maybe they are all very sensible. I would greatly appreciate any further insight from anyone out there who knows.

The idea puzzling me is "microfoundations." As I understand it, the rational expectations revolution in macroeconomics, linked to the names Robert Lucas, Edward Prescott, Thomas Sargent and others, demanded that macroeconomic theories shouldn't just be built as coarse-grained effective theories operating at the macroscale and written in terms of macroscopic variables such as inflation, unemployment, etc. Rather, a good theory henceforth was to link macroeconomic outcomes back to the behaviour of the individual agents in an economy, i.e. to their microeconomics behaviour. Such as theory would have "microfoundations."

To my physicist mind, this seems entirely sensible, so far. A difficult project, no doubt but sensible. By analogy, of course, this just seems like the effort to derive thermodynamics (a macroscopic theory) from the underlying behaviours of individual particles, which is the project of statistical mechanics. Deriving theories at higher levels from behaviours at lower levels is, when possible, a natural scientific project -- it offers unification or, if it can't be carried through, points to problem areas from which new ideas are likely to come.

Now, I have also read that much of the impetus for the rational expectations movement was the famous Lucas Critique which, if I understand it correctly, says that you can't reliably base policy interventions on simple regularities observed in macroeconomic data (a historically observed tradeoff between unemployment and inflation, for example). That regularity existed, after all, in the context of the policies prevailing in the past. Change the policies and those changes, by influencing the way people act and anticipate the future, may well strongly change or destroy the regularity on which you had based your plans. Again, plausible and sensible, it seems to me.

So, I can see the attraction of theories with microfoundations -- theories, that is, giving a plausible account of how macroeconomic reality emerges out of the micro reality and actual behaviour of millions of people and firms in interaction.

Now my puzzlement. As far as can tell, the idea of "microfoundations" as actually used in macroeconomics isn't quite how I described it above, i.e. seeking to base macro theory on a plausible account of the behaviour of individuals. Rather, in economics (through the work of Lucas) it has come to mean theories in which individuals and firms are hyperrational optimizers of their utility over a span of time (they solve a complicated optimization problem over their lifetime). This no longer seems so plausible, and on this point, a commenter from Mark Thoma's blog captures my feelings on this quite clearly:

Microfoundations would be important if there were clear evidence that they represented the truth. For example, if there had been a series of experiments demonstrating that individuals are rational and make decisions so as to maximize some measurable quantity called utility, it would be important that macro models were consistent with this and the most direct way of ensuring that would be to incorporate rational utility-maximizing households into the model.

The fact is that there is no such evidence. Microeconomics is not based on empirical evidence, and the approach used in microeconomics has no special claim to the truth. So, leaving aside the fact that the way macroeconomics uses micro (i.e., in a way that many microeconomists don't approve, ignoring aggregation issues) there's no logical reason why macro needs to even be consistent with micro.

His point seems to me very well put -- if "microfoundations" as currently interpreted don't give foundations to anything, then a theory having them has no advantage. Theories with microfoundations (as interpreted in this odd sense) have no more claim to relevance than anything else. Indeed, we might say they are even worse as they are almost certainly demonstrably inconsistent with real behaviour at the micro level.

Again, I'm not an expert on this. But I see this kind of argument breaking out over and over among economists. I often think I must have it wrong, so please if I do, someone let me know.

UPDATE

While writing the above, I happened to find and read a couple of things that clarified matters quite a bit for me. My take seems to be shared by economists as well, although I'm not sure the few things I read are representative. First, Maarten Janssen of the Tinbergen Institute published an excellent short review of the idea of microfoundations in 2008. He describes the history, but notes that key criticisms of the idea do center in the "plausibility" of the rational expectations approach. That is, including expectations in macromodels is sensible, but everything depends on how you include them:

The approaches discussed so far... all postulate rational behavior on the part of economic agents and some notion of equilibrium. If expectations are important, it is postulated that agents’ expectations concerning important variables coincide with the model’s predicted values concerning these same variables.

And he mentions several branches of research criticizing this view and testing it, in particular, testing whether in a decentralized economy economic agents may learn over time to have expectations that are consistent with those that are assumed by the rational expectations hypothesis:

The general conclusion of this literature is that due to the feedback from expectations to economic behavior, the outcomes of an economic model with learning agents do not converge to the rational expectations solution. It then follows that the microfoundations literature mentioned so far has not really succeeded in deriving all macroeconomic propositions from fundamental hypotheses on the behavior of individual agents. The requirements of methodological individualism have thus not been satisfied by the microfoundations literature that has pre-dominantly presumed that individuals behave rationally...

I cannot say I'm surprised. So we're left with theories that only go one short step toward the idea of microfoundations, and, in my view, can't claim they have given microfoundations to anything -- the use of the word in these models is totally unwarranted, and I think way overstates what they achieve.

I think much the same point of view is expressed by Michael Woodford, himself a big name in macro modelling. In a response to an essay by John Kay critical of modern macroeconomics and its unrealistic assumptions, Woodford in a roundabout way eventually says, well, yes, I agree:

It has been standard for at least the past three decades to use models in which not only does the model give a complete description of a hypothetical world, and not only is this description one in which outcomes follow from rational behavior on the part of the decision makers in the model, but the decision makers in the model are assumed to understand the world in exactly the way it is represented in the model. More precisely, in making predictions about the consequences of their actions (a necessary component of an accounting for their behavior in terms of rational choice), they are assumed to make exactly the predictions that the model implies are correct (conditional on the information available to them in their personal situation).

This postulate of “rational expectations,” as it is commonly though rather misleadingly known, is the crucial theoretical assumption behind such doctrines as “efficient markets” in asset pricing theory and “Ricardian equivalence” in macroeconomics. It is often presented as if it were a simple consequence of an aspiration to internal consistency in one’s model and/or explanation of people’s choices in terms of individual rationality, but in fact it is not a necessary implication of these methodological commitments. It does not follow from the fact that one believes in the validity of one’s own model and that one believes that people can be assumed to make rational choices that they must be assumed to make the choices that would be seen to be correct by someone who (like the economist) believes in the validity of the predictions of that model. Still less would it follow, if the economist herself accepts the necessity of entertaining the possibility of a variety of possible models, that the only models that she should consider are ones in each of which everyone in the economy is assumed to understand the correctness of that particular model, rather than entertaining beliefs that might (for example) be consistent with one of the other models in the set that she herself regards as possibly correct.

So I feel that my suspicions and objections aren't misplaced, despite my vast ignorance. One other excellent article I recommend is this one from 2011 in which Woodford details the history of modern macroeconomics over the past century. Nothing I've read has given such a complete and clearly explained exposition, while it seems being balanced along the way (or so it seems, to my physicist's eyes).

UPDATE

Ole Rogeberg kindly let pointed me to this post by economist Noah Smith who makes some of the same points -- but from the position of someone with far economics domain knowledge than myself.

Search This Blog

This blogexplores the potential for the transformation of economics and finance through the inspiration of physics and the other natural sciences. If traditional economics has emphasized self-regulation and market equilibrium, the new perspective emphasizes the myriad positive feed backs that often drive markets away from equilibrium and cause tumultuous crashes and other crises. Read more about the idea.

Who am I?

Physicist and science writer. I was formerly an editor with the international science journal Nature and also the magazine New Scientist. I am the author of three earlier books, and have written extensively for publications including Nature, Science, the New York Times, Wired and the Harvard Business Review. I currently write monthly columns for Nature Physics and for Bloomberg Views.